Thursday, 15 February 2018

In today’s post, we will be
previewing an article produced by this author that was very recently published
in the Journal of Sustainable Finance & Investment (available here).
The article is concerned with recent developments within the ‘Principles of
Responsible Investment’ (PRI) initiative that is being undertaken by the U.N.,
with the focus being on the proposed incorporation of the leading credit rating
agencies (for the most part) and their products. The emphasis of the article is
on explaining the view that, based on the historical development of the credit
rating industry, inducting them into the potentially systemic-altering movement
carries with it great risk, and it is that risk that is analysed within the
article.

The article begins by not
explaining the developments within the PRI, but by examining a concept known as
‘rating addiction’. Using the literature to provide context for the concept, an
assessment is undertaken to examine how the leading rating agencies have been
correctly identified as being central
to the Financial Crisis (and many other issues) but have not only survived
through these socially-challenging periods, but actually prospered – the
article advances the claim that the reason for this phenomenon is ‘rating
addiction’ which, as one would likely surmise, relates to the notion that the
financial system is addicted to the
products and therefore the agencies, which has the effect of protecting the
agencies against any meaningful punishment for their actions. The article
examines the literature that discusses the concept of ‘ratings reliance’, which
is similar concept to ‘rating addiction’ in many ways but focuses more on the
regulators’ incorporation of the ratings into
their procedures for a number of elements, like bank capital requirements, for
example; the effect of this reliance has been, according to the literature, a
systemic-level of ‘outsourcing’ of regulatory responsibility to third-parties,
so much so that the regulators have come to ‘rely’ on the ratings. However, it
is arguable, and the article makes this distinction, that ‘reliance’ and
‘addiction’ are two separate phenomena, because ‘addiction’ carries the
connotation of the strong inability to remove oneself from the process – much
like a drug (or any other commonly witnessed addictions).

Upon declaring that rating
addiction does indeed exist, and is fact prevalent, the article goes on to
discuss the technical issue of whether ‘reliance’ and ‘addiction’ are indeed
separate, describe the same thing, or are different positions within the same
linear causal pattern. It is proposed in the article that rating addiction
supersedes everything else because, essentially, it predates the regulatory usage
of the products of the agencies. Using business history literature,
particularly that developed by Professor
Marc Flandreau and his doctoral colleagues, the article presents a picture
whereby, due to the economic landscape in antebellum America i.e. before the
American Civil War, it was the economy
that became addicted to the ratings of the agencies, and not a case whereby, as
others have suggested, regulators pushed the ratings onto the marketplace –
with the ratings being used to deal with the issues being raised by the
expansion of the United States, market participants began to realise that
ratings were the most cost-effective way of ensuring (to the greatest extent
possible) that credit extended to a person or a company would be repaid.
Flandreau discusses this at length across a number of fascinating articles, but
the conclusion to be drawn from his research is that, quite simply, the
regulators in 1933, and in 1975 (to note two key dates in the regulatory
induction of ratings; 1933 saw the Office of the Comptroller of the Currency
induct the ratings, and 1973 [later promulgated in 1975] saw the SEC formally
induce and protect the rating agencies into the modern marketplace) were responding to the marketplace, not influencing the marketplace;
understanding this dynamic is absolutely vital to understanding the reason why
agencies managed to prosper despite being widely identified as being key actors
in the Financial Crisis.

The above hints at the
viewpoint that is it actually investors and bond-offering organisations that
lay at the cause of rating addiction, which is to some extent true, and on that
basis the article then looks at why this may be. One of the key aspects that the
article examines is the concept of ‘agency’ and the related theories, which
provide a useful tool with which to examine the relationship between an
investor, their institutional investor, and the rating agencies. For example,
whilst in the 1840s when the first commercialised
rating agency came into being the
system involved lenders providing credit to other marketplace actors in a very
commercialised manner, the modern system relies on the constant flow of
resources; the clearest example to use is an institutional investor, like a
pension fund, whereby the ‘lender’ is made of a large number of dispersed
investors with relatively small funds, and partake in a system that has
investment managers who take the lead on who to lend to, why, and where. The
obvious problem with this scenario is that dispersed fund contributors would
find it difficult, and more importantly inefficient,
to monitor the actions of their ‘agents’ on a daily basis; the solution, within
the modern marketplace at least, has been to define parameters within which the
‘agents’ can act, with easily digestible and identifiable ‘ratings’ being a
common choice. On the other hand, to protect the system, regulatory (and
legislative) bodies have enforced rules that do the same thing but for different
reasons, which is why many institutional investors have their investing ability
capped by certain rating levels i.e. AAA, or the top ratings prescribed by the
relevant rating agency. Yet, as that is the case, the question is then what
does that mean when the investing system itself is changed, or at least being
proposed to change?

This issue of changing the
investing ‘system’ slightly exaggerates the proposals being put forward by the
PRI, but the sentiment is close enough. The initiative, which sees a number of
large investment practices come together to promote the increased incorporation
of sustainable investment practices, whereby key Environmental, Social, and Governance
(ESG) concerns are incorporated into investment practices, is essentially the
movement being developed by the PRI. In the article the proposals set forth by
the PRI are discussed in detail, but the result of that examination is to
assess the proposals currently being considered which set out a plan of action
for the rating agencies to a. be inducted into the PRI’s movement, and b. have
that induction predicated upon the agencies’ incorporation of ESG concerns into their rating processes. Whilst some
have championed this idea, there is a problem that is outstanding which forms
the crux of the article; whilst the agencies profess to already incorporate ESG
into their rating processes, the facts of this are disputable, and for a number
of reasons. Firstly, as discussed in the article, the rating agencies are no
exactly clear on the levels of ESG incorporation into their analyses, although
all say that it forms a part; the majority of responses revolved around the
declaration that, for their part, they see financial data as the key driver of
their rating analyses, with ESG components playing not much more than a bit
part on their deliberations. Whilst the PRI are, as a result of this
understanding, aiming to encourage rating agencies to increase their usage of
ESG considerations, the responses of the agencies suggest that operationally,
and moreover culturally¸ they are not
seriously inclined to do so. Yet, the biggest issue of all is that the agencies
are notoriously guarded when it comes to disseminating information related to
their methodological processes, and this is for a number of reasons – many of
the reasons relate to protecting their position, and others relate to
protecting themselves when things go wrong or they act in a transgressive
manner. Nevertheless, it is on this basis that the article argues that
inducting the agencies, in their current form and with their current culture in
mind, into the PRI, is a great risk. Whilst that claim may be sensationalised,
to an extent (although this author is clear on the view that agencies need to
be treated with great care when it comes to incorporation), there is a
technical element which describes that risk more accurately. Using the research
of Professor Kern
Alexander,there is an argument
to be had that if the sustainable investment movement continues and regulators
place a value on operating in such a manner, then the linking of, say,
sustainable finance credit ratings to something like bank capital requirements,
could pose a huge risk in relation to the historical conduct of the rating
agencies. In doing so, the sustainable finance movement would, in essence,
become the latest credit rating-related vehicle with which the systemic safety
of the economy could be placed in jeopardy; then, as always here in Financial Regulation Matters, the
obvious question is whether the economy, and society moreover, is healthy
enough to withstand another shock so soon after the Financial Crisis.
Ultimately then, the aim of the article is to present an account of the recent
movements of the agencies, and present an account that is determined to
highlight the potential risks of incorporating the rating oligopoly into such a
progressive and much needed movement; understanding the historical trajectory
of the rating agencies provides the rationale for doing so.

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